Business Model

This quote comes to us from Ms. Allie Webb, the Founder and CEO of Drybar a blow dry only salon. A blow dry salon is not like any hair salon. It offers, just as name indicates, blow dry and styling. Drybar is a pioneer in this niche and does $40 million in revenue a year. In an interview with The Wall Street Journal she was asked why she raised her prices recently. And she offered this answer,

Ms. Webb: We always were $40 in New York. We tried to keep prices $35 [elsewhere] as long as we could, but you know things go up: rent, health insurance, incentives. There’s just a lot of different things that got more expensive. We had to raise the prices to keep the business model as it was.

I am willing to bet that someone as innovative and entrepreneurial like Ms. Webb, one who invented the category getting customers to pay for something they do for free, knows exactly why she raised her prices and is simply saying the best answer one could give to explain price increases. You have seen this done perfectly by Starbucks and repeatedly too.

We are increasing prices because …. ( anything but we found out customers value and charge that price).

Ms. Webb does just that, citing cost reasons, rent and salaries. I don’t have to repeat that a customer could care less about a marketer’s cost. Ms. Webb would be the first to admit that a customer getting their hair blown out does not think about offsetting Drybar’s rent. However using cost reasons to correct your past pricing sins is a perfect tool. It does allay customer concerns and push backs.

However what Ms. Webb added in the end is concerning.

We had to raise prices to keep the business model as it was

Again I believe she does not believe that statement. And no business should. You never raise prices to preserve your business model. Because your business model is nothing more than – how do you get your fair share of value you created for the customer. Pricing is the simplest way to capture the value created. If you are increasing prices without increasing value you are simply getting more than fair share of what you created. Such a business model is unstable and will be disrupted.

No one can preserve their model, let alone preserve it by raising prices. Someone else will always find a way to deliver customers more value, do it cheaper than you could and share a greater portion of that value with customers that you do. Your option is to do that before others do it to you.

Like this:

When you think of best in class product managers, what companies come to mind?

All the valley companies? In fact don’t we have a label, “West Coast Product Management”? True or not sounds cool like NFL’s West Coast Offense. If you were to do unaided recall survey among most in social media it is highly likely we will find these in the top of the list, (in no particular order)

twitter

facebook

Dropbox

Pinterest

Square

When you think about what sets these top notch product managers apart, what traits come to your mind? There is a question in Quora that slices it even further,

What distinguishes the Top 1% of Product Managers from the Top 10%?

If we assume normal distribution of product manager quality levels, this question asks what distinguishes those who are 2.34 sigma over mean from those who are merely 1.285 over mean. That is some precision.

And the answer that received 2500 votes lists a long list key traits. I do not know how one can measure many of them objectively. And this most popular and long answer not once mentions the word, “customer”. Other not so popular answers list customers and understanding customer needs. But none of the answers take it to next step – from understanding and serving customer needs to getting fair share of value created by serving those needs.

Even my own survey (that used forced point allocation ) on product management skills, did not include aspects of customer value creation and value capture. If you think about it, all the traits listed in Quora (Design, Copywriting, …) or in my survey (Strategic thinking, Hustle, …) these are really secondary to the True North function of a product manager.

Understand customer needs – Analytic skills, Usability analysis, etc.

Decide on (prioritize) needs to serve based on value created and the share of value you can get – strategic thinking, forecast and measure, …

Build an offering, Maximally Valued Product, that does it better than alternatives and in cost effective way – Simplify, Design, Hustle, Influence, make technical trade-offs

Position it in the minds of customers – Presentation skills, Copywriting and the rest

Make it easy for customers to get it – Sales enablement, Buying experience etc

After all, what is a product but a value delivery vehicle? And all those great design, frictionless UI and copywriting do not make a product until you define a set of customers whose needs you meet and who want to pay you for fulfilling that need.

The common definition of MVP is the Minimal Viable Product. The other MVP you should start thinking about – if you are serious about ringing the cash register – is Maximally Valued Product. All that validated learning is useless if you cannot find whether customers are willing to pay for the value your product creates or if you cannot ring the cash register.

I introduced this new MVP in my last article.

A Maximally Valued Product for a given customer segment is the product version that adds most value to the customers while enabling marketer to extract their share of the value as price premium.

It is a very specific definition and it is customer centric. It does not leave the market wide open. It focuses on value created by filling a need (the need can be anywhere on this consumption spectrum). It closes with your share of the value created. After all charging for value created remains the simplest of all business models.

Who has access to these kinds of resources to do elaborate customer segmentation or complex analytics to find value and price perception. Especially startups.

Here is a teaser on a lean startup’s method for answering these questions. You will have to wait for the next article on how to analyze the results from this method.

Let me give you a very simple tool to answer two of these questions – segmentation and value perception. For finding pricing you can talk to me.

Think of your customer’s value perception as a resource allocation problem. Say you give your customers 100 coins. You present them an assortment of benefits or a need fulfilled. Their job is to allocate those 100 coins such that they give more coins to the benefit they value more and vice versa.

Before you rush into this you need to know the following

What are the key benefits do you want to measure vs. a long list of features? You find that from initial customer discovery.

Of those what can you deliver through your product and do it better than competition?

How do you account for non-interest? That is how do you weed out those that are simply not interested in any of these benefits but did the coin allocation simply because you asked them to.

When you collect data from reasonably large sample (100-300) of target customers you will end up with a distribution of value perception. The data have the segmentation dimensions and the value perception of benefits.

Let me tell you more on how to analyze this distribution to find segments and value perception in my next article.

“The minimum viable product is that version of a new product which allows a team to collect the maximum amount of validated learning about customers with the least effort.“

In this explanation there is no mention of which customers and what is customer value. It is inward focused definition. Since it does not talk about customers or value it does not talk about pricing. Some variations of the explanations have included pricing component to MVP.

However measuring customer value or charging for the value delivered is not the primary concern in defining or building a Minimum Viable Product.

I would like to take this concept and flip it on its head and show you what Apple builds.

When Apple builds its products it is packed with only those features that are valued by its customers and it can charge for it. It may look the opposite when you consider the fact that they were the first to introduce all inclusive iMac and MacBooks. But had they thought they would not have been able to extract a price premium for those included features they would not have included them, I will come to that in a minute.

Sure they could have built product versions that lacked some of those features and competed with other low-end products. As Steve Jobs would have said, “if we knew how to make it inexpensive without making the product crap, we would have done it”. Apple chose to go after those higher willingness to pay customers and added product features that extracted more value in the form of higher prices than the cost to add those features.

See below how they extracted value from flash drive capacity and 3G in iPad.

What Apple is doing is starting with the customer segment they want to target (they don’t have to get the iMac in billions homes) understand what these customers value and willing to pay a premium for, and deliver them just that at a premium price.

As opposed to a Minimum Viable Product, Apple builds and delivers Maximally Valued Product. Here is my academic sounding definition for it

A Maximally Valued Product for a given customer segment is the product version that adds most value to the customers while enabling marketer to extract their share of the value as price premium.

Note the segment specificity, value creation and value capture aspects of the definition unlike the definition of Minimum Viable Product.

The Maximally Valued Product packs features for sure but these are the features customers value and willing to pay for. It also lacks many features, sure customers may value them but if that does not flow into better prices, why bother?

For most people in the valley – running startups, working for them or mentoring them to become insanely successful – the sequence is clear. There is no argument. Anyone who says otherwise simply doesn’t get it.

Wouldn’t it help if we all understand and speak the same thing when we say Strategy, Product or Business Model?

Here is a very simple definition for these terms. Not made up, not changed to fit present day mania. These are well established definitions for running any business. And those disrupting status quo to create frictionless something or the other are not exempt from these definitions.

Strategy – Here is a simpler and relatable definition – Strategy is about making choices under constraints (and most times under uncertainty). Choosing the only option available to you (say going for 4th and 24 with 7 points down and 20 seconds on the clock) is not strategy. Choosing all options available because you are not resource constrained is not strategy. Strategy is making hard choice, under limited resources (there are only situations with limited resources) and the outcome is far from known.

For a VC firm their strategy could be the type of ventures they even want to consider, be it the pedigree or market it plans to play in. For accelerators it would appear they could fund anything and everything from enterprise to social media startups but their choice is to limit investment choices based on the stage of the startup.

For a startup (or more generally, a business) the choices start with which customer segment and need they want to target first – a segment with compelling unaddressed need, that is not only big enough but also had big growth opportunity. You can serve all customers and all needs. The old adage about being all things to all people goes well here.

For example, Salesforce.com choosing to serve enterprise customers with significant pain-points (and IT budget to spend) and reach them through highly effective direct sales team vs. building out Chatter as competition for Facebook is their strategy. Another example is Netflix choosing streaming over DVD by mail as the future.

Strategy does not end with the first choice. If you have to make a hard choice among available options (and most times under uncertainty) then it is strategy. First it is the segment to target, then there are choices on routes to market, product, product features and when to deliver, pricing and communication.

That is strategy.

Business Model – You can do a Google search on all kinds of theoretical works on business model. In practical terms, business model is answering two questions

Together these two constitute your business model. You could be like some of the group buying sites and take a share of value you did not help create. Or you could be miss out getting your fair share. In either case your business will sooner or later will fail because it runs out of value to take or in latter case run out of cash.

You could introduce a third party (or fourth, or fifth) in the value flow – say advertisers, content producers – and decide to capture value indirectly. If your product adds compelling net new value to customers you chose to serve, charging for it remains the simplest of all business models.

And as an astute reader you noticed there are choices to make in defining the business model. It could be in how best to deliver value or how to capture value, whether to capture value upfront or align with value deliver (subscription). That is strategy does not go away when you move to business model.

“customers have jobs to be done and they hire products for those jobs”

So we could say product is the value delivery medium. This is not to trivialize it. Product offers the greatest opportunity to innovate – to deliver something that does the ‘job’ better than any other alternatives available to customers, to deliver most natural way to use it, to do so in the most cost effective way for the venture that is building the product, to make it sticky, etc.

Again there are choices to make – what to build, when, how etc. More strategy in building the right product.

Given these, you decide whether one is greater than the other. For startups, Fred Wilson argues finding the product-market fit first, deciding on strategy then business model.

For startups that begin as a personal problem the founder is trying to solve with the assumption that there are many others with the same problem it would appear

start with the initial iteration

keep refining it through user discovery

build a large enough user base, getting early adopters to spread the word

worry about monetization later

… is not only the only recipe but one that is guaranteed to deliver success (can you say Facebook, Twitter, Instagram, Pinterest?)

The argument for product first approach should not be because of what we know to be successful startups or because of one’s inability to start with strategy first.

Did you consider the possibility that when you do thousands of experiments – thousands of founders with the same personal problem, trying to address it in thousands of different ways – some experiments are going to succeed?

Quick! Write an inequality equation using two ‘>’ (greater than) signs and

Product

Strategy

Business Model

Depending on where you stand and which articles you read recently there are six possible permutations. If you had recently read what Fred Wilson, a Venture Capitalist, wrote you are mostly likely to write down

Product > Strategy > Business Model

Is that all to it? According to research done by four business schools, this permutation defines only one of two classes of VCs. More precisely, there are two schools of thoughts of how VCs make investing decisions. The second class of VCs believe the right permutation is,

Strategy > Business Model > Product

While Fred Wilson makes a compelling case to get product-market fit correct, then define your strategy and then worry about making money, a VC who falls in the second category will argue, equally eloquently, strategy (making choices about segmentation and needs to serve) first, finding how you add and capture value (business model) is next and what the offering (product) is last.

Effectual – Instead of doing market research, competitive analysis, value analysis etc, go build something and keep iterating on it and building a growing customer base. Then worry about strategy and business model.

Causal: Start with customer segmentations and their unmet needs (or jobs to be done). Make choices on the right segment you should target first and understand its value perception, alternatives and willingness to pay. Define a product version that serves that segment and offer at a price they are willing to pay.

There exists a class of VCs who apply effectual reasoning and there exists another that applies causal reasoning. You can see Fred Wilson falls in the effectual bucket.

So when you have two classes of entrepreneurs and two classes of VCs, the next obvious question is which pair would work together well. The aforementioned research suggests, cognitive similarity (“I like how you think”) was a decisive factor in how VCs decide choose to invest in startups.

Their study was conducted on 49 partners from different VC firms, by presenting them 16 different hypothetical investment opportunities and asking them to rate how likely are they to fund these ventures. From these 784 data points, the researchers employed conjoint analysis to tease out the influence of individual factors on VC’s decision. This is approach is far better than stated preference studies that ask VCs for their rating and data mining studies that succumb to data errors.

The number one deciding factor? How similar the thought process is between the VC and the founder. The researchers call this cognitive similarity, which has nothing to do race, national, education, gender or other physical characteristics. It is how a founder thinks and how similar it is to VC’s thought process. Higher the similarity, greater the chances of getting funding.

Everything else, including the perception of the team, its experience and commitment (human capital) are influenced by VC’s reading of founder’s thought process.

“A founder who demonstrates cognitive similarity with a VC is more likely to be perceived in a positive light, and viewed as better positioned to make effective use of his or her human capital”

All other positive attributes we hear about, the product’s competitive advantage, scalability, founding team’s ability to hustle, their focus etc seem to be bestowed after the fact.

What does this mean to you as a startup founder seeking venture funding?
You are better off seeking those VCs who think like you do in terms of product, strategy and business model. If you think market demand and opportunity size first and pitch to Fred Wilson you are most likely going to come back empty. On the other hand you at least get to play if you think product-market fit first. So knowing how you reason and seeking as venture partners only those who think like yourself saves lots of wasted time and agony.

Will Fred Wilson and other VCs admit to this influence of cognitive similarity in their investment decisions? More broadly, do VCs know and admit to the influence of cognitive similarity on their funding decisions?

No, they do not recognize this hidden factor. And I expect comments from a few stating so. In the same study that teased out this hidden factor, the researchers asked an explicit question on how much weight VCs place on cognitive similarity with founders. VCs rated this as the the least important factor, but when they had to place a bet given a profile of venture and its founders, the hidden influence of cognitive similarity came out loud and clear.

Finally, is Fred Wilson right? Is effectual better than causal? The proponent of this classification, Professor Saras Sarasvathy, goes one step beyond this mere classification. She argues great entrepreneurs are ‘effectual’. They opt for doing things vs. analyzing things. I do not subscribe to this latter part of her theory regarding what defines entrepreneurial greatness.